Fixed-income Exchange-traded Funds Research Articles

Fixed-Income ETFs: A liquidity illusion?

Exchange-Traded Funds (ETFs) have revolutionised the asset-management industry with high liquidity and low bid-asks allowing investors to access a diversified portfolio cheaply. The desirable liquidity characteristics of ETFs are, however, in contrast with their behavior in crisis periods. This paper studies the breakdown in the fixed-income ETFs (FIETFs) market, during the peak of the COVID-19-driven liquidity shock of March 2020. We argue that FIETFs provide an illusion of liquidity and the liquidity mismatch between the ETF and the underlying manifests itself in terms of very significant differences between the price and the Net Asset Value (NAV). We run a further analysis on the dislocation by comparing it with equity ETFs. Comparisons suggest that the cost of liquidity is very high for fixed-income ETFs with significant tracking errors during volatile periods in contrast with the better-behaved equity ETFs. Further analysis on the performance patterns of FIETFs indicates that both the price and NAV might have deviated from fundamentals with an overreaction in the ETF price accompanying an underreaction in the NAV. We also study the phenomena of ‘dealer inventory management’. FIETFs are uniquely different from equity ETFs in that the authorised participant (arbitrageurs) tend to be the large banks that are also market-makers in the underlying securities. Therefore, we show that the incentives of the arbitrageurs may not always be aligned towards arbitraging the price-NAV differential. In a novel empirical study using trading volumes and position changes for the largest corporate bond ETF (LQD), we suggest that inventory management by the larger broker-dealers may have exacerbated the dislocation. We believe that the conflicting objectives of dealers have further increased due to high balance-sheet costs imposed upon them post the Global Financial Crisis. Finally, we propose the use of derivatives, in particular credit derivatives, for the risk management of liquidity shocks. We show that the drawdown from rapid liquidity shocks can be reduced significantly through exposure to credit convexity.

Examining Intraday Fixed Income ETF Liquidity: Is it More Expensive Near the Open?

In this article, the authors analyze the relationship between time of day and bid-ask spread for US-domiciled fixed income exchange-traded funds (ETFs) with US dollar exposure. They aggregate millions of national best bid and offer (NBBO) spread data points into 168,324 sample observations according to 166 ETFs over 78 intra-day time intervals across 13 calendar quarters. The authors find that both before and after they add controls, average spreads are highest in the morning, supporting the argument that investors trading on the basis of NBBO spreads should avoid trading near market open. After falling from morning peaks, spreads generally flatten out the rest of the day, even after adding controls. Therefore, the analysis does not support the argument that investors should systematically avoid trading US fixed income ETFs near market close. TOPICS:Exchange-traded funds and applications, fixed-income portfolio management Key Findings • Average spreads are highest in the morning before and after adding a battery of variables, supporting the argument that investors trading on the basis of national best bid and offer (NBBO) spreads should avoid trading US fixed income ETFs near market open. • After falling from morning peaks, spreads generally flatten out the rest of the day, contradicting the argument that investors should systematically avoid trading US fixed income ETFs near market close. • Our findings do not negate other trading best practices such as using limit orders, consulting a block desk for large orders, and not trading during the open and/or closing auctions.

Fixed Income ETFs and Bond Liquidity

This paper examines the impact of Fixed Income Exchange-Traded Funds (ETFs) on corporate bond liquidity. I find that corporate bonds ETFs decrease the transaction costs of their constituent securities. The use of two distinct quasi-natural experiments, that control for the identification issues of self-selection and of an index effect, establishes a causal relation between ETF ownership and bond liquidity. Moreover, ETFs do not deteriorate the liquidity of their bonds during ETF arbitrage and market stress events. The ETF trading volume appears to be the transmission mechanism driving the results.

Factor-based optimisation and the creation/redemption mechanism of fixed income exchange-traded funds

Fixed income exchange-traded funds (ETFs) trade on organised exchanges, often with narrow spreads, liquidity and pre- and post-trade transparency. The tremendous success of fixed income ETFs relies critically on the efficient functioning of the ETF creation-redemption mechanism which drives the funds' market price to stay closely in line with the underlying values of the bond portfolios they represent. Creation of fixed income ETFs faces challenges though because of the less liquid nature of the markets for many bonds. In this article, we explain how custom fixed income baskets can be used with exchange-traded funds in a systematic, auditable and repeatable manner. We use factor-based optimisation to create ETF baskets for one or more ETFs and with one or many counter-parties. We conclude that optimisation can improve the efficiency of ETF basket creation, which in turn induces higher liquidity and tighter spreads, benefitting investors.

Do ETFs outperform CEFs in fixed income investing?

Purpose – For a number of reasons ranging from their more recent introduction to their perceived lesser excitement relative to stock-based peers, there have been few studies of fixed income (mainly bond) exchange-traded funds (ETFs). The purpose of this paper is to fill the void by comparing performance measures of fixed income ETFs to fixed income closed-end funds (CEFs). Design/methodology/approach – This paper examines operating characteristics as well as risk and performance measures of all available fixed income ETFs and CEFs in the USA over the last five and ten years ending on December 31, 2014. Operating characteristics include expense ratios, annual turnover rates, tax cost ratios, and tracking error ratios. Performance measures include average annual returns, risks (measured by standard deviations), and risk-adjusted returns (measured by Sharpe ratios and Sortino ratios). Findings – This study finds material and significant difference in a variety of expenses, return measures, and risk measures. Sharpe and Sortino ratio significance is highly dependent on whether net asset values or market values serve as the dependent variable. ETFs would be the preferred choice of fixed income investors who are presumed to be focussing on market-based return measures. Originality/value – This paper empirically compares operating characteristics as well as risk and performance measures of US fixed income ETFs and fixed income CEFs in the same Morningstar categories over the last five and ten years.

Practical Applications of Bond Market Price Discovery: Clarity Through the Lens of an Exchange

The more than $2.5 billion a day transacting in fixed-income exchange traded funds (ETFs) provide the opportunity to study comparative pricing behavior with the underlying bond market. Despite a rich vein of academic research on ETF pricing behavior in the equity markets, not much work has been done on the fixed-income side, Matthew Tucker , Managing Director at BlackRock , points out. Tucker co-authored the research with Stephen Laipply , Director at BlackRock . Both are in the Fixed-Income Portfolio Management Group. This Practical Applications report outlines their empirical analysis in Bond Market Price Discovery: Clarity Through the Lens of an Exchange , which appeared in the Fall 2013 issue of The Journal of Portfolio Management . The research covers ETF bond indices in the investment-grade, municipal, high-yield and Treasury markets, with comparative implications among the different sectors and during different market periods. The authors describe when differences between price discovery in over-the-counter bonds and fixed-income ETFs are most acute and outline a simple trading strategy to take advantage of mispricing.

Tracking Performance of Leveragedand Regular Fixed-Income ETFs

This article examines the tracking performance of the leveraged and regular fixed-income exchange-traded funds (FIETFs) on four major indexes: medium-term Treasury, long-term Treasury, investment-grade corporate, and high-yield corporate bond indexes. All sample FIETFs display significant tracking errors, and these tracking errors are much larger for funds on the longer maturity bond index. In addition, funds tracking corporate bond indexes show greater tracking errors than those on Treasury bond indexes. Finally, tracking errors are larger for leveraged FIETFs than for regular FIETFs and increase as the magnitude of target leverage increases for bull/bear funds. Over multiple trading days such as a week, the return deviation of a leveraged FIETF can be driven by both the net asset value (NAV) deviation due to fund management tracking error and compounding effect due to the daily rebalancing nature of LETFs. While both return deviation components are significant on a weekly basis, the size of the NAV deviation dominates that of the compounding deviation, reflecting the difficulty for fund managers to track fixed-income indexes.

Bond Market Price Discovery: Clarity Through the Lens of an Exchange

Fixed-income exchange-traded funds (ETFs) are bond portfolios that trade on a stock exchange. They present a unique opportunity to compare the valuation of fixed-income securities on exchange-driven and over-the-counter (OTC) markets. Tucker and Laipply quantify the price discovery properties of fixed-income ETFs, focusing in particular on the speed at which the ETF and OTC bond markets reflect new price information. They find that fixed-income ETF price movements can potentially serve as a leading signal for subsequent OTC bond market movements (as proxied by bond market indices), especially when volatility is high. The authors also explore potential trading strategies that capitalize on this dynamic. <b>TOPICS:</b>Exchange-traded funds and applications, fixed-income portfolio management, exchanges/markets/clearinghouses

Tracking Performance of Leveraged and Regular Fixed Income Exchange-Traded Funds

Tracking Performance of Leveraged and Regular Fixed Income Exchange-Traded Funds

On the Performance of Fixed Income Exchange Traded Funds

We evaluate the performance of fixed income Exchange Traded Funds (ETFs). We find that Treasury ETFs are indeed able to track their benchmarks, but that Investment Grade corporate bond ETFs underperform their benchmarks and High Yield corporate bond ETFs even severely underperform their benchmarks. We provide evidence that the transaction costs of the underlying bonds are a key determinant of an ETF’s underperformance. We conclude that indexes consisting of bonds that are more costly to trade are more difficult to track.